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Saturday, April 16, 2016

Taxes, Preferences and Privileges

If two people or two families have the same income but pay different income taxes, it is worth asking why? The 2015 federal income taxes have much higher tax rates for wage income than dividend income or capital gains. For a new college graduate fortunate enough to find a job earning a salary of $40,000, their income will be taxed as wages with federal tax liability of $3,973.75, assuming the standard deduction and one exemption.

If the $40,000 wages were taxed as dividends are taxed they would have paid nothing; no federal income tax at all. That is because a single tax payer can earn up to $47,750 of dividend income, or capital gains, or a combination, and after allowing for the $4,000 exemption and the standard deduction of $6,300 there is no tax on the remaining taxable income of $37,450.

If two college graduates find $40,000 a year jobs, marry and file a joint return on their $80,000 wage income they will pay $7,987.50 in federal taxes. If the $80,000 wages were taxed as dividends are taxed they would have paid nothing; no federal income tax at all. That is because a married couple with no children can earn up to $95,500 of dividends, capital gains or a combination, and after allowing for two $4,000 exemptions and the standard deduction of $12,600 there is no federal income tax on the remaining taxable income of $74,900.

Dividends or capital gains for an individual filer have no tax up to $47,750 of taxable income but only a 15 percent tax rate above that for dividend and capital gains. While zero tax makes for great savings a 15 percent tax rate saves at least 10 percent and up to 24.9 percent on tax rates compared to the tax rates on wage income above $47,750.

For an individual filer with $75,000 of wage income their federal tax will be $11,968.75, assuming one exemption and the standard deduction. If the income was $50,000 of salary and $25,000 of dividends, their tax drops to $9,806.25, a saving of $2,162.50. If the couple above each earned $35,000 salaries and $10,000 of dividend income their tax would drop from $7,987.50 to $6,487.50, a saving of $1,500.

A tax advantage for dividends and capital gains gives wage earners an incentive to save and invest in stocks: better to earn some of that tax free income. Tax free dividends favors older people with more years to save, but the law applies to everyone and so amounts to a preference for dividend income over wage income. I would call it a preference for dividend income rather than a privilege because everyone has the chance to adopt their personal finance to take advantage of the preference. It’s not always that way.

Some of the wealthy and the well placed have the ability to define their income. Wage earners get a w-2 form and have to pay tax on wages. Corporate Boards and corporate officers have the ability to define their pay in non-wage types of stock option arrangements to avoid the w-2 and convert income to be reported on Form 1099. The privileged have the ability to opt for the 15 percent tax rate instead of the 36.9 percent tax rate that applies to taxable wages at or above $464,850.

A million dollars of wage income for a married couple with a joint return and standard deduction pays a federal income tax of $319,865.44, but only $135,675.00 for 1099 income a saving of $184,190.40. I hear people say wealth has its privileges, but wealth creates the privileges for a selected few who use their tax privileges to perpetuate an upper class and the growing income inequality.